In addition, a debt instrument does not provide for contingent payments merely because it provides for an option to convert the instrument into the stock of the issuer, into the stock or debt of a related party, or into cash or other property in an amount equal to the approximate value of such stock or debt. However, this exception does not apply when the debt instrument provides for contingent payments other than the conversion feature and those contingent payments are neither remote nor incidental.
Assuming the CoCo instrument is characterized as a debt instrument, the instrument provides for one or more contingent payments (the contingent interest) that are neither remote nor incidental. As a result, the debt instrument would be a contingent payment debt instrument subject to the non-contingent bond method described in Treas. Reg. Sec. 1.1275-4(b). Although a conversion feature alone does not cause a convertible debt instrument to be subject to the non-contingent bond method, the possibility of a conversion is nevertheless a contingency. Therefore, the comparable yield for a convertible debt instrument subject to the non-contingent bond method is determined under Treas. Reg. Sec. 1.1275-4(b) by reference to comparable fixed-rate non-convertible debt instruments. Moreover, the projected payment schedule is determined by treating the stock received upon a conversion of the debt instrument as a contingent payment.
Under Treas. Reg. Sec. 1.163-7, the amount of interest that is deductible each year on a contingent payment debt instrument is determined under Treas. Reg. Sec. 1.1275-4 However, certain provisions of the Internal Revenue
Code, such as Sec. 163(l) and Sec. 249, may affect an issuer’s ability to deduct the interest computed under the non-contingent bond method.
Sec. 163(l) provides that no deduction is allowed for any interest paid or accrued on a disqualified debt instrument, which is any indebtedness of a corporation that is payable in equity of the issuer or a related party. Under Sec. 163(l), indebtedness is payable in equity only if (1) a substantial amount of the principal or interest is required to be paid or converted, or at the option of the issuer or a related party is payable in, or convertible into, such equity, (2) a substantial amount of the principal or interest is required to be determined, or at the option of the issuer or a related party is determined, by reference to the value of such equity or (3) the indebtedness is part of an arrangement that is reasonably expected to result in a transaction described in either (1) or (2), above. Principal or interest is required to be so paid, converted, or determined if it may be required at the option of the holder or a related party and there is a substantial certainty the option will be exercised.
The legislative history behind IRC 163(l) indicates that an instrument is treated as payable in stock if it is part of an arrangement designed to result in payment with or by reference to such stock, including certain issuances
of a forward contract in connection with the issuance of debt, non-recourse debt that is secured principally by such stock, or certain debt instruments that are convertible at the holder’s option when it is substantially certain that the right will be exercised. The Conference Report further states that it is not expected that Sec. 163(l) will affect debt with a conversion feature if the conversion price is significantly higher than the market price of the stock on the issue date of the debt.
Sec. 249 provides that no deduction is allowed to the issuing corporation for any premium paid or incurred upon the repurchase of a bond, debenture, note or certificate, or other evidence of indebtedness that is convertible into
the stock of the issuing corporation, or a corporation in control of, or controlled by, the issuing corporation, to the extent the repurchase price exceeds an amount equal to the adjusted issue price plus a normal call premium on bonds or other evidences of indebtedness that are not
convertible. However, Sec. 249 does not apply to the extent the corporation can demonstrate to the satisfaction of the Secretary of the US Treasury that such excess is attributable to the cost of borrowing and is not attributable to the conversion feature. For purposes of Sec. 249, a conversion is a repurchase.
Sec. 249 applies only to a premium paid to repurchase a convertible debt instrument. However, Sec. 249 applies to a conversion of the debt instrument into stock having a value in excess of the debt instrument’s adjusted issue price.